Chp 1.
- Hunt For Bargains in places people are not looking. Lower liquidity, smaller cap stocks
- Only invest in those situations where you are knowledgeable and confident, and only those situations. ( similar to Buffett quote of 'swing at only one of twenty pitches'). Stick to your ping-pong 'net serves'
- Look at downside risk rather than upside potential. Upside will take care of itself, but the way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety.
- Relying on objective measures like a company's book value and historical earnings to determine value may help eliminate some of the emotional and institutional biases likely to be found in more future-based valuation methods. Buffett adds to this that investing in fundamentally good businesses, as opposed to stocks priced cheaply in statistical terms is probably why Buffett has become Graham's most successful disciple.
- Buffett focuses on well-managed companies, that have a strong franchise, brand name, or market niche.
- His investments are concentrated in businesses he understands well and possess attractive underlying economic (meaning they generate lots of cash) and competitive characteristics.
- Finding these stocks is still a hard task, because many things can go wrong and Peter Lynch of Buffett are exceptionally good at making tough calls
- Corporate events offer another area where you can make money:
- Spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, distributions
Ch 2.
- If pre-select investment areas that put you ahead of the game before you start, the most important work is already done. You'll be picking and choosing from an already outstanding menu, and your choices are less likely to result in indigestion
- Spinoffs:
- Stocks of spinoff companies, and shares of the parent companies significantly and consistently outperform market averages
- Spinoffs in SP500 companies often will be subject to a huge amount of indiscriminate selling because the funds that own the new companies are too large to be concerned with the new smaller company
- The largest stock gains occurred in the 2nd year after the spinoff
- Reasons to own a spinoff:
- Institutions don't want it (and the reasons don't involve investment merits)
- Host Mariott would be spun off with huge debt and unpopular real-estate assets(hotel market was terrible at the time). Because the situation looked terrible, most people would be discouraged from additional research on the new stock
- Host Mariott would be 15% of the 2B market cap of its parent company, which would make it too small for most of the original shareholders to want to own
- Insiders want it
- Are the managers of the new spinoff incentivized along the same lines as shareholders
- Will they receive a large part of their potential compensation in stock, restricted stock, or options? Is there a plan for them to acquire more? When all public documents have been filed, look in this area first
- Host Mariott new CEO would be Stephen Bollenbach, who was the architect of the spinoff and had successfully helped Donald Trump turn around his failng hotel / gambling businesses
- A previously Hidden investment opportunity is created or revealed
- Typically a great business or statistically cheap stock is uncovered as a result of of the spinoff. In the Host case, tremendous leverage was the result.
- The tremendous leverage would magnify returns on equity if it turned out to be more attractive than it initially appeared.
- Digging for research involves reading multi-hundred page corporate documents and mountains of SEC filings, like Form 10
- Identify where you think you will find opportunity in the documents
- After you've identified a spot that has opportunity, then start digging
- It takes between 6 - 9 months after the initial disclosure of a spinoff to occur. In the Host case it took over 1 year
- Form 10
- Look through table of contents to identify areas you actually want to review
- Pro forma statements - show what the company would be making if it was a separate entity
- Economic interests of insiders
- 'Business of the company' - Strattec 10F 'based upon current product commitments, the company believes ford will become its second-largest customer during fiscal 1996' The companies statements did not include any business related to Ford. Since the current 2nd largest customer did about 16% of business, Ford would be responsible for about 16% more.
- A spinoff that involves a parent company divesting a highly regulated industry may provide a prelude to a takeover because it makes the target a more attractive takeover
- Partial Spinoff
- Only sell a partial amount of a division
- If shares are distributed to current parent company shareholders, it is generally better than an public offering
- By knowing the parent company market cap, and after the spinoff is complete, the child company market cap, you can figure out what the rest of the businesses in the parent company are worth
- After analyzing the parent company there may be opportunities to purchase the existing business cheaply.
- Sears needed to spinoff AllState and Dean Witter. After their spinoff, Sears $27B in sales was worth only $1.5B in market cap
- Right's offering
- Gives you the right to buy shares in a newly spun off company, usually when the parent company needs additional capital
- Look for oversubscription privileges and the motives of the insiders
Ch 4. - Risk Arbitrage and Merger securities
- Generally involves buying stock after a deal is announced
- Company A announces it will buy B (currently at $25) for $40. Company B then jumps to $38.
- Risks are the deal doesn't not complete and the stock price returns to $25, or lower or that the deal takes a very long time to complete (typically deals close in 1 to 18 months)
- This may happen because of regulatory issues, financing, extraordinary change in a company's business, discoveries during the due diligence process, or management personality problems
- Ex: HBJ goes to buy Cypress Garden
- HBJ @ 51.87, CG at $4.50, it then moves to $7.50
- The deal is .16 shares of HBJ for CG which can be locked in at $8.30 by shorting HBJ and buying CG in the appropriate amounts
- The deal makes sense from a business perspective
- No financing since it's all stock
- Very small so there are no regulatory issues
- The only vote required was by CG shareholders
- Author believes competition is too high now in Risk Arb. Spreads are tighter and too many things need to go right. A bad streak of luck or macro event will destroy a portfolio.
- Merger Securities are actually very lucrative
- Instead of stock or cash, bonds, preferred stock, warrants, and rights are used as sweeteners
- As a general rule, nobody wants these securities and they typically are undervalued as a result
- Ex: Super Rite Foods
- Management wanted to take the company private but they ended up getting a competing bid, so they had to include some other things
- The winning bid ended being:
- $25.25 in cash,
- $2 face-amount new issued preferred stock yielding 15% annually(this was a small amount and would probably be disregarded by the current investors)
- warrants to buy 10% interest in the new company (warrant is right to buy stock at a specified price) set at $0. 1 warrant for every 21.44 shares which was worth between 25c and 50c / share. (since this was also a tiny amount it would be disregarded as well). They ended up trading for $6
- According to the projections, in 3 years the new entity would be earning $5 / share in free cash flow. So a modest projection would be each new share being worth $50.
- Super Rite traded at $25.5 to $26 before the merger closed, which would equate to 75c for the preferred stock and warrants, but it might return to $17 if the deal collapsed. In the end, buying preferred stock and warrants in the open market seemed like the best idea
- Warrants were worth $40 in 2 years, and preferred stock, which sold for 55% of face value went up to 100%
- Viacom / Paramount
- Also many merger securities
- There were CVR (essentially put option w/ capped payout) which guaranteed $48 selling price if Viacom stock > $25.
- 5 Year warrants at $70, Viacom current at $32. Entitled the holder to 1 share of Viacom stock for $70 cash or $70 face-value worth of subordinated debt. This debt was trading at 60% of face value = $42. So, the 5 year warrant could be purchased and then be paid with the subordinated debt, which means you could buy a option at $42 good for 5 years.
- Common stock is almost always a terrible investment in bankrupt companies
- Bonds
- All types of bonds
- Bank Debt
- Trade claims - claims from the companies suppliers who didn't get paid for goods, materials, or services provided before the bankruptcy
- Typically these holders get securities in the new company after it emerges from bankruptcy, bonds or common stock
- The opportunity comes from analyzing the new common stock by reading the disclosure statement. This filing is made with the bankruptcy court and can be obtained directly from the company or SEC filing 'registration statement'. Disclosure statement is better because it provides management's future projections and past complications.
- A study showed that these new distributed stocks outperformed the market by 20% during the 1st 200 days of trading. However, it was the stocks with the lowest market value that performed the best
- Only buy good businesses - strong market niche, brand name, franchise or industry position
- Buy companies that were overleveraged due to a takeover or LBO
- Product liability lawsuits from a discontinued or isolated product line
- Slumming - cheap compared to similar companies because analyst dont' cover it, nobody knows about it, or bad stigma
- Ex: Charter Medical still pretty leveraged after bankruptcy but management were trying new things to make up for lost revenue. It ended up working and stock tripled, but then didn't go any higher.
- Knowing when to sell:
- Trade the bad ones, invest in the good ones.
- If you bought because of a corporate event, once it is widely known, it is time to sell.
- If the business is still difficult, but lots of analysts start speaking positively of the stock, sell it.
- Corporate Restructuring: Selling or shutting an entire division that is materially relevant to the entire company
- Companies close or sell major division to stanch losses, pay off debt, or focus on more promising business lines
- Often times, the division being sold was masking the company's other businesses.
- Two ways to profit, 1. after it is announced, often there is time to see what will happen. 2. Finding a company ripe for restructering
Ch 6
- Recapitalization
- company repurchases a large portion of common stock in exchange for cash and/or securities
- The left over stock is called a stub stock and many have returned 5x to 10x
- Ex: $36 dollar stock, company recaps by giving $30 in bonds to common stock holders that carry 10% interest. Earnings before were $3. Pre-tax earnings were $5. After recap, earnings are still $5, but $3 is paid out as interest. Remaining $2 is taxed at 40% = .80c and remaining $1.20 is distributed to shareholders. Stock was trading at P/E of 12 pre recap, and will trade at about 8 after.
- Assumed growth of 20% before recap. Growth of 20% in eps = $6. EPS = $1.80 * P/E 8 = $14 from about $9.60
- Recaps rarely happen now, they were more popular in the 80s. However, you can emulate the leverage by buying LEAPS and warrants
- Options market tends to be undervalued during these special situation events.
- During a spinoff, a call option can be split into 1 share of each of the two companies. Since after a spinoff shares generally rise, this is not always taken into account with options models.
Ch 7
- Look in the WSJ, IBD, Outsanding Investors Digest(LEAPS candidates), Turnaround LEtter(orphan stocks from bankruptcy and restructuring stocks), value oriented funds (look up their picks that are related to special situations)
- SEC filings for the most interesting stocks from above: 10K, 10Q, Schedule 14A (executive stock ownership, sock options, overall compensation)
- Extraordinary Events filings:
- 8K - acquisition, asset sale, bankruptcy or change in control
- S1, S2, S3, S4 - S1 -> S3 are registration statements for companies issuing new securities, S4 is for securities being distributed through merger or bother business combinations, exchange offer, recapitalization, or restructuring. S4 sometimes combined w/ a proxy statement where shareholder vote is required
- Form 10 - spinoff distribution
- Form 13D - owner of 5% or more must disclose holdings and their intentions regarding the stake is for investment purposes. If the purpose is for exerting control or influence, this filing may be a sign of an extraordinary corporate change
- 13G is if institutional holder only is holding for investment purposes
- Schedule 14D-1 - tender offer statement. provides useful background info on a proposed acquisition. You can get these from the information agent listed on the ad announcing the offer.
- Schedule 13E-3, 13E-4 -E-3 is a going private transaction, E-4 is the tender offer statement when a company is buying back its own shares and disclosures are more extensive than usual, so read these carefully.
